Streetwise for Sunday, February 3, 2019
As I pointed out in a recent seminar, investing is the process of increasing the value of assets over a specified time period. Moreover, there is a substantial body of knowledge supporting the supposition that the most pragmatic approach utilizes a portfolio of equity investments.
A prudent selection of stocks will both protect their inherent purchasing power from the ravages of inflation and taxes, while allowing their value increase as well. Poor selection and management will not only destroy the value of your portfolio but could also jeopardize your desired degree of financial freedom.
Although there is no one correct approach to building a portfolio, every methodology will entail dealing with the future, which means dealing with a degree of risk. For years, investors relied on stalwart companies with household names to consistently deliver both dividends and rising share prices.
Unfortunately, events such as the Great Recession have shown in grim detail that even the mightiest of companies, AT&T, General Motors and General Electric to name a few, can disappear or at best be decimated.
Every investor must underwrite a degree of risk to achieve future rewards. This especially true in today’s markets. Although risk can be mitigated, it can never be eliminated. So, what exactly is risk?
Risk is not homogenous. Rather it is a combination of market risk, where market forces determine an asset’s price, and interest rate risk, where asset values are subject to interest rate fluctuations.
Purchasing power risk plays a role, meaning returns may not keep up with taxes and inflation. A portion of risk is non-systematic, defined as company specific risk. This is eliminated through diversification.
Your willingness to bear risk is a critical determinant in planning out your investment strategy. Higher risk, if managed properly, will usually be rewarded with higher rates of return.
Unfortunately, investors often have a skewed concept of risk. Risk is not that certain components of your portfolio might suddenly decline in price. Prices of financial instruments fluctuate continuously. Judge a portfolio against a predetermined set of criteria over a defined period and do not worry about what happens in the interim.
Consider Apple. Despite the decimation of its share price, combined with a slowdown in iPhone sales, Apple posted first quarter earnings of $4.18 per share an all-time high! Will its share price subsequently recover? Over time that is likely to be inevitable.
Trying to pick the exact day and time to purchase a security does not reduce risk. Market timing can be nerve-wracking, and its usefulness is highly questionable.
However, you always have two weapons with which to vanquish risk, diversification and time. Diversification is sort of modern-day alchemy. It has the effect of transforming a heterogeneous group of securities into a portfolio with predictable characteristics.
The reason it works is that the weakness of one security is balanced against the strength of another. In total, the group is stronger than the individual parts would appear to indicate.
They say time heals all. While it might not be a cure-all, time will help heal an underperforming portfolio. One-year investments are risky. The longer you invest for, the more likely you are to come out ahead.
There is a Far Eastern saying that a warrior knows no desire. As an investor, it is imperative that you know no desire either. In civilian mode, you are free to wish for prosperity and bull markets.
As an investor, you must be totally objective. You must not prefer bull markets over bear markets. If you do, you will soon be seeing horns and leather where fur and claws are waiting to embrace you. You must be willing to take what the markets give you.
As you move closer to financial freedom, the concept of investing will take on new meaning. You will become increasingly adept at managing a diversified portfolio as you will become comfortable with what you feel is a palpable degree of risk.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.